I have two decades of experience trading currencies and fixed income instruments. My market analysis skills were honed during my tenure as global head of trading for firms such as Scotia Capital and BMO Nesbitt Burns. Since joining OANDA in 2006 as Chief Currency Analyst, I have been publishing a daily commentary on global markets. I lead a team with 24/7 North America, Asia and Europe forex market coverage. Born in Dublin, Ireland, I hold a degree in Economics and Finance from Trinity College Dublin.

Forex: Greenback Bulls On The Run

Dollar bulls expecting to score on the back of diverging rates between a hawkish Federal Reserve and dovish European Central Bank (ECB) are now in full retreat.

With the release of the dovish Federal Open Market Committee’s March meeting minutes, and Fed Chair Janet Yellen’s recent remarks highlighting “considerable slack” in the economy, many long-dollar positions are being squeezed as the market drastically prices out an early rate hike by the Fed.

Economically, the U.S. is sound and much further ahead of Japan and Europe. According to the International Monetary Fund, the U.K. is the European Union’s outlier on the growth front, while China, with its questionable economic data, (this week it was weaker Chinese export data) is everyone’s problem. These are the ingredients that have U.S. Treasurys looking like the better bid. U.S. 10′s touched a four-week low yesterday (+2.65%), as traders dampened their enthusiasm and bets for U.S. policymakers to move aggressively toward a hike in interest rates.

Chinese Economy in a Lull

Weaker Chinese data will always boost the safer-haven demand of a number of other assets like bonds (specifically Bunds, Treasurys, and Japanese Government Bonds) and currencies like the yen. Traders’ wagers on the futures exchange yesterday put the likelihood that the Fed will start raising rates in July 2015 at +63%, for June the percentage actually fell to +41% compared with +54% projected last week. The fixed-income market is basically re-pricing the curve, pushing out the “lower for longer” theme.

Yesterday’s and this morning’s asset moves have only served to confuse. Equities are falling and the Treasury market is rallying — this is technically the norm, as investors shift cash flows from equities into a safer-haven asset class like bonds. But, the dollar also has come under pressure, printing a number of new quarter lows versus its Group of Seven counterparties. The recent sharp selloff in equities provided a supportive climate for safe-haven securities but did not include the USD this time around. Dealers noted that currencies were currently diverging from traditional risk barometers.

Why? Forex volatility is at a historically low level courtesy of extremely “easy” monetary policies from the developed economies. The combination of low volatility, Fed quantitative easing, and a weaker “net savings” position has the USD underperforming (a distinct long-term competitive disadvantage to other G-7 members). This has led to other central banks like the Reserve Bank of Australia, Bank of Canada, Norges Bank and now the ECB to change policy guidance to counter a tightening of their monetary conditions from stronger currencies versus the USD. All central bankers can hope for is that the U.S. economy will recover enough for Fed guidance to be challenged, and that the front-end U.S. Treasury yield curve to finally break higher, giving G-7 central banks some relief. Otherwise, investors and dealers will be trading in the new “norm” of low forex volatility and contained intraday ranges.

Treasurys Gain on Fed Forecasts

The U.S. Treasury curve has priced in +100bp of rate hikes for the next three years, with the first hike in 2015. According to the Fed and fixed-income watchers, historical examples of Fed rate ‘normalization’ suggest the process can be significantly more aggressive. In the forex market, volatility remains subdued, handcuffed mostly by central bank actions. Currently, forex volumes are pricing sharply lower the cost of more rapid Fed tightening. When there is a need to re-price anything differently, the short-term forex volumes should be capable of rising from their current ultra-low levels, moving both spot forex and cross positions for a brief period.

Any shocks from a re-pricing of the Fed’s reaction are expected to be fleeting in the current environment, leaving longer dated maturities well anchored as policymakers focus on the short end. It’s up at the “front” where Yellen and company will be busy guiding and smoothing expectations and helping to form forex trends. These trends will again smooth out volatility as investors buy on dips using forex to overshoot Fed-tightening expectations. Now, all this market requires is a break in the lower for longer cycle. For any hardcore reaction, the forex and fixed-income market need a tightening Fed, otherwise it’s back to watching paint dry. Today’s low levels of forex and equity volumes are “historically a sign of extreme leverage and poor capital allocation.” A Fed on the move will break this – the more the Fed’s policy drains cheap USD liquidity, the stronger the USD becomes. For now, the lower for longer argument is hurting the greenback at least until investors become fixated on something else.

This article is for general information purposes only. It is not investment advice or a solution to buy or sell securities. Opinions are the authors; not necessarily that of OANDA Corporation or any of its affiliates, subsidiaries, officers or directors. Leveraged trading is high risk and not suitable for all. You could lose all of your deposited funds.

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